Monday, February 20, 2012

This is an unedited version of my article for Sunday Times 19/02/2011.

This week’s announcement by the Government that the Irish
banks will be issuing loans to small and medium sized enterprises (the SMEs) under
the cover of a sovereign guarantee has raised some eyebrows.

Throughout the persistent lobbying to underwrite credit
supply to the struggling SMEs, it was generally resisted by the majority of
economists and analysts, who argued that the Irish state is in no financial or
fiscal position to provide such a measure. Having backed banks’ debts via the
original 2008 State guarantee and emergency loans from the Central Bank of
Ireland by the letter of comfort, the Irish state had also underwritten the
risks associated with the commercial real estate development and investment
assets through Nama. In addition, via rent supplements and mortgage interest
supports, the government is propping up a small share of other banks assets and
the rental markets.

Now, it’s the SMEs turn.

Per Central Bank’s own stress tests, estimated worst-case
scenario defaults on all assets in the core Guaranteed banking institutions are
expected to run at around 14.6%. SMEs loans had the worst-case scenario default
rate estimate of 19%. We can argue as to the validity of the above estimates,
but much of the international evidence on lending risks suggest that SMEs loans
are some of the riskiest assets a bank can have. Add to this that we are in the
depth of the gravest recession faced by any euro area country to-date,
including Greece and you get the picture. Without state backing, there will be
no lending to smaller firms. With the state guarantee, there will be none,
still.

Subsidizing risker loans in the banks that are scrambling to
deleverage their balancesheets, struggling with negative margins on their
tracker mortgages and facing continued massive losses on loans might be a
politically expedients short-term thing to do. Financially, it is hard to see
how the Irish banking system crippled by the crisis and facing bleak ‘recovery’
prospects in years ahead can sustain any new lending to the SMEs.

Eleven months after the stress tests and seven months after
the recapitalization by the taxpayers, Irish banking sector remains as
dysfunctional in terms of its operations and strategies as ever.

Top level data on Government Guaranteed banks, provided by
the Central Bank of Ireland, shows that in 2011, loans to Irish residents have
fallen by €63.25 billion on 19% with €30.3 billion of this decline coming from
the non-financial private sector – corporate, SME and household – loans. Loans
to non-residents are down €40.9 billion or 29%.

Over the same period of time, deposits from Irish residents contracted
€42.5 billion or 18%, with Irish private sector deposits down €11.2 billion or
10% on 2010. Non-resident deposits have shrunk 35% or €36.1 billion at the end
of 2011 compared to the end of 2010.

The Government spokespeople are keen on pushing forward an
argument that in recent months the numbers are starting to show stabilization.
Alas, loans to Irish residents outstanding on the books of the guaranteed banks
are down 7% for the last three months of 2011 compared to the third quarter of
the same year. All of this deterioration is accounted for by losses in private
sector loans which have fallen €21.7 billion or 12% in Q4 2011 compared to Q3
2011. Deposits from Irish residents are up €2.04 billion or 1% over the same
period, due to inter-banks deposits rising €2.3 billion, while private sector
deposits are down €384 million.

The ‘best capitalized banks in Europe’ – as our Government describes
them – are not getting any healthier when it comes to core financial system
performance parameters. Instead, they are simply getting worse at a slower pace.

The outlook is bleaker yet when one considers top-level risk
metrics for the domestic banking sector. On the books of the Covered Banks, domestic
private non-financial sector deposits are currently one and a half times
greater than all foreign deposits combined. On the other side of the
balancesheet, ratio of assets issued against domestic residents to assets
issued against foreign residents now stands at 159% - the highest since
December 2004. Again, this means that banks balancesheets are becoming more,
not less, dependent on domestic deposits and assets, which in turn means more,
not less risk concentration.

This absurdity passes for the State banking sector reforms
strategy that force Irish banks to unload often better performing and more
financially sound overseas investments in a misguided desire to pigeonhole our
Pillar Banks into becoming sub-regional players in the internal domestic
economy. In time, this will act to reduce banks ability to raise external
funding and, thus, their future lending capacity.

Aptly, the latest trends clearly suggest increasing concentration
and lower competition in the sector across Ireland. While ECB only reports a
direct measure of market concentration (or monopolization) for the banking
sector through 2010, the trends from 1997 reveal several disturbing facts about
our domestic banking. Firstly, contrary to the popular perspective, competition
in Irish banking did not increase during the bubble years. Herfindahl Index –
the measure of the degree of market concentration – for banking sector in
Ireland remained static at 0.05 in 1999-2001, rising to 0.06 in 2002-2006, and
to 0.09 in 2009-2010. Secondly, back in 2010, our banking services had lower
degree of competition than Austria, Germany, Spain, France, UK, Italy,
Luxembourg, and Sweden. On average, during the crisis, market concentration across
the EU banking sector rose by 8% according to the ECB data. In Ireland, this
increase was 29% - the fastest in the euro area. Lastly, the data above does
not reflect rapid unwinding of foreign banks operations in Ireland during 2011,
or the emerging duopoly structure of the two Pillar banks.

Meanwhile, the banks continue to nurse yet-to-be recognized
losses on household, SMEs and corporate loans as recent revision of the
personal bankruptcy code induced massive uncertainty on risk pricing for mortgages
at risk of default. In addition, Nama constantly changing plans to offer
delayed repayment loans and mortgages protection, destabilizing banks risk
assessments relating to existent and new mortgages, property-related and
secured loans. The promissory notes structure itself pushes the IBRC to
postpone as much as possible the winding up process.

To summarize, evidence suggests that seven months after the
Exchequer completed a €62.9 billion recapitalization of the Irish banks, our
banking system is yet to see the light at the end of the proverbial tunnel. Far
from being ready to lend into the real economy, Irish banks continue to shrink
their balancesheets and struggle to raise deposits. Their funding profile remains
coupled with the ECB and Central Bank of Ireland repo operations – a situation
that has improved slightly in the last couple of months, but is likely to deteriorate
once again as ECB launches second round of the long term refinancing operations
at the end of this month. In short, our banking is still overshadowed by the
zombie AIB, IL&P, and IBRC.

Let’s hope Bank of Ireland, reporting next week, provides a
ray of hope. Otherwise, the latest Government guarantees scheme can become a
risky pipe dream – good for some short-term PR, irrelevant to the long-term
health of the private sector and damaging to the Exchequer risk profile.

CHART

Source: Central Bank of Ireland

Box-out:

This week, Minister Richard Bruton, T.D. has made a rather
strange claim. Speaking to RTÉ's News, Mr Bruton said that last year's jobs
budget had created 6,000 jobs in the hotel and restaurant sector. Alas, per
CSO’s Quarterly National Household Survey, the official source of data on
sectoral employment levels in Ireland, seasonally adjusted employment in the
Accommodation and food service activities sector stood at 119,100 in Q3 2009,
falling to 118,200 in Q3 2010 and to 109,700 in Q3 2011. While jobs losses in
12 months through Q3 2011 – the latest for which data is available – were
incurred prior to June 2011 when the VAT cuts and PRSI reductions Minister
Bruton was referring to were enacted. But even if we were to look at seasonally
adjusted quarterly changes in hotel and restaurant sector employment levels,
the gains in Q3 2011 were a modest 1,400 not 6,000 claimed by the Minister. In
reality, any assessment of the Jobs Programme announced back in May 2010 will
require much more data than just one quarter so far reported by the CSO. That,
plus a more careful reading of the data by those briefing the Minister.

Disclaimer

This blog represents my personal views and is not reflective of the views or opinions held by any company, contractor, client or employer I work for currently or have worked for in the past. These views are not an endorsement to take any action in the markets or of any political position, figures or parties.

“It is not true that people stop pursuing dreams because they grow old, they grow old because they stop pursuing dreams.” Gabriel Garcí­a Márquez

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"Getting worse more slowly is not the same as getting better", Prof. Brad DeLong